The Decision Cycle for Downside Risk and Income-Focused Strategies
March 8, 2017
Carlos Chujoy, CFA
Employees Retirement System of Texas
The Decision Cycle for Downside Risk and Income-Focused Strategies
StatementGenerally portfolios are designed to address the needs of a variety of investors.i.e. Pension plans, endowments, family offices, high net worth, etc. These needshave ranged from improving the growth of the underlying assets to the reductionof overall portfolio risk, or both. A way to address these needs has been to diversifyinto other asset classes.
The Decision Cycle for Downside Risk and Income-Focused Strategies
ProblemExpanding the investment allocation to other asset classes did not bring in thedesired diversification benefits at a time when they were needed the most.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Cumulative Returns
Equities have delivered the strongest returns over the past 26 years. 60/40 performance is heavily influenced by equity returns
The Decision Cycle for Downside Risk and Income-Focused Strategies
Drawdown
Strong equity returns have come at a price. 60/40 performance is heavily influenced by equity returns
The Decision Cycle for Downside Risk and Income-Focused Strategies
60/40 shows accrues strong returns with a balanced risk profile. All return distributions exhibit negative skewness and positive kurtosis.
Selected Stats
The Decision Cycle for Downside Risk and Income-Focused Strategies
Risk allocation of a 60/40 equity/bond portfolio is driven by themost volatile asset class. In fact, 92% of the total contribution tototal portfolio risk is driven by equities.
Concentration Risk
The Decision Cycle for Downside Risk and Income-Focused Strategies
Steps to address problem1. Know what your portfolio looks like. Understand the return distribution.2. Understand how assets behave during different market regimes.3. Could a portfolio exhibiting different exposures to other assets done better?4. Identify what that investment opportunity set looks like.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Return Distribution
Seek to improve the return distribution of the current 60/40 by mitigatingleft tail risk and improve risk-adjusted returns.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Why Options?
Positive IV-RV spread = richly priced options = establish income focused strategies Negative IV-RV spread = cheaply priced options = establish protective risk strategies
The Decision Cycle for Downside Risk and Income-Focused Strategies
Strategies Analyzed
Short Call/Put
Bull/Bear Call Spreads
Bull/Bear Put Spreads
Long/Short Straddles/Strangles
Long/Short Iron Condor
Long Put
Put Spread Collar
Short Risk Reversal
Note: All strategies are treated as overlays to a 60/40
The Decision Cycle for Downside Risk and Income-Focused Strategies
Downside Protection
All downside protection option-based strategies delivered better returnsthan a 60/40 with lower levels of risk.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Income Enhancement
Most of the income focused option-based strategies delivered similar returns to a 60/40 but with better risk-adjusted profiles.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Returns Across Multiple Strategies
The Decision Cycle for Downside Risk and Income-Focused Strategies
Correlations for the income focused and downside protection option based strategies were negative over the past 26 years.
Cross Strategy Correlations
The Decision Cycle for Downside Risk and Income-Focused Strategies
Regime Drivers
We use the Leading Economic Indicator (LEI) to represent the 4 stages of a business cycle and shade areas to denote expansion, slowdown, contraction and recovery
We use the VIX as a proxy for expected volatility.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Regime Drivers
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest Results
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest Results
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest Results
Use of a regime-based framework combined with option-based strategieshas shown promising results.
We have applied this framework to a real equity portfolio and have tracked thelive performance of a paper traded options overlay portfolio. The results attainedhave been in-line with expectations.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest
“The process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital.” - Investopedia
“It is a term used in oceanography, meteorology, and the financial industry to refer to testing a predictive model using existing historic data. It is a special type of cross-validation applied to time series data.” – Wikipedia
The Decision Cycle for Downside Risk and Income-Focused Strategies
Importance
Environment to test an idea
Helps to quantify the success of a strategy
Provides insights as to the behavior of a strategy over time
Allows to perform comparative analysis across a range of strategies
Serves as a way to cross-validate results
Pitfalls
Unrepresentative time period. In-sample.
Underestimates survivorship bias
Ignores market impact
Overfit of data and data mining
Underestimates hidden exposures
It is just a model